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Contingent Convertibles

(Bloomberg) -- It’s a high-yield investment with a hand grenade attached. An asset carried gingerly with the hope that it won’t explode, leaving investors in a hole. Welcome to a class of securities that’s all the rage in Europe: contingent convertibles, also known as CoCo bonds. A cross between a bond and a stock, CoCos are helping banks bolster capital to meet tougher regulation designed to prevent a repeat of the taxpayer bailouts of the financial crisis. Some investors are skeptical that the extra yield CoCos offer really reflects their dangers, but nearly 200 issues worth a combined 160 billion euros ($181 billion) have been snapped up in the first five years since they came to market in 2013. While CoCos are supposed to make financial markets safer, critics question whether regulators have unwittingly created new risks that have yet to be tested by a major crisis.

The Situation

CoCos faced their first market challenge in 2017, when Banco Popular Espanol SA, Spain’s sixth-biggest bank, was swallowed by rival Banco Santander SA to prevent its collapse under a mountain of bad property loans. The takeover wiped out 1.25 billion euros worth of Popular’s CoCos. Then in 2019, Santander tested the market again by declining to call 1.5 billion euros in 6.25 percent CoCo notes that investors hoped it would. The muted reactions in the debt market to both events was considered a win for the inventors of the risky debt instruments. The most popular form of CoCos are used to raise what’s known as Additional Tier 1 (AT1) capital, a lender’s first line of defense after equity against financial shocks. While hedge funds seeking higher yields are keen buyers of CoCos, the bonds are also purchased by asset managers hungry for income in the current low interest rate environment. Most CoCos paid a coupon of between 6 and 9 percent in early 2019, roughly double or even triple that of more secure senior bank bonds.

The Background

Regulators cleared the way for the issuance of CoCos because they set the stage for bondholders — rather than taxpayers — to feel the pain of bank rescues and gave lenders a way to raise funds without further diluting shareholders. They are “perpetual,” which means they may never be redeemed, though the hope among buyers has always been that banks would repurchase the bonds at the first opportunity. CoCo interest payments can be switched off if capital ratios fall to dangerously low levels (that’s the contingent part). If a bank’s financial health deteriorates further and it needs to fill a hole in its balance sheet, CoCos can be written down to zero or converted into equity (that’s the convertible part). The need for such a financial instrument has been met differently in various regions: While Europe opted for CoCos to boost Tier 1 capital, U.S. banks are employing a form of preferred stock and China’s lenders are using a cross between the two. While CoCos are technically bonds (and thus interest payments can be made from pretax earnings), they display many of the properties of an equity.

The Argument

CoCo bonds were developed partly because regulators noted that investors often did a better job of predicting which banks would buckle during the financial crisis than officials had themselves. CoCos are meant to harness this “wisdom of the crowd” by putting bondholders on the front line, giving them a vested interest in the health of wobbly banks. The broader concern has been that problems with a specific bank or a hiccup in the financial system could cause investors to suddenly wake up to the inherent risk and flee all CoCos, destabilizing the corporate bond market and worsening the problem at hand. Critics charge that the securities are too complex to be properly understood, too varied and too much like equity to be considered bonds. The biggest test for the CoCo market will come when a large, global bank imposes losses on its bondholders. Until then, critics say, we won’t know whether CoCos helped save the banking system — or helped sink it.

The Reference Shelf

A QuickTake Q&A on how bondholders were wiped out in the rescue of Banco Popular.

Andrew Haldane from the Bank of England and Piergiorgio Alessandri of the Bank of Italy set out the theoretical case for CoCos in a 2009 paper. Haldane, the BOE’s chief economist, described them in a speech in 2011.